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1
The tax treatment of funded pensions
Edward Whitehouse1
The tax treatment of pensions is a critical policy choice in the transition from a
public sector, pay-as-you-go system to one in which all or part of pensions are
provided through individual, privately-managed pension accounts. A generous
tax treatment will promote pension saving but may be costly in terms of
revenues forgone and encourage tax avoidance. The distributional
consequences may also be undesirable if higher income individuals are better
able to take advantage of tax reliefs.
In countries with mature funded pension systems — such as the
Netherlands, Switzerland, the United Kingdom and the United States —
pension funds are worth an average of 85 per cent of GDP. Private pensions
account for a major part of private-sector savings flows, are an important
supplier of capital to industry and play a large and growing role in providing
retirement incomes. These figures alone mean that it is vital to give the tax
treatment of pensions careful consideration.
1 Director, Axia Economics, London. Thanks are due to David Lindeman and Robert Palacios ofthe World Bank, Andrew Dilnot and Richard Disney of the Institute for Fiscal Studies inLondon, Willem Adema and Mark Pearson of the OECD in Paris and Paul Johnson of theFinancial Services Authority in London for their help and advice. The usual disclaimer applies,and the paper is a personal view.
2
This paper is structured as follows. The next section considers a number
of different possible ways of taxing pensions. Section 2 provides a descriptive
overview of the tax treatment of pensions in a range of countries. Section 3
extends the analysis to compute a summary measure of the generosity of tax
incentives, the marginal effective tax rate on pension saving. Section 4
considers the link between the taxation of pension funds and the tax treatment
of the underlying assets, particularly equities and bonds, in which they invest.
Section 5 examines the deductibility of contributions. Sections 6 and 7 look at
the importance of pension funds and associated tax incentives in aggregate.
Section 8 assesses the objectives for taxing pensions, the options and the
arguments while section 9 concludes.
1. Possible pensions taxation régimes
Three transactions constitute the process of saving via a funded pension
scheme, each of which provides an occasion at which taxation is possible:
• when money is contributed to the fund, normally by employers and
employees;
• when investment income and capital gains accrue to the fund; and
• when retired scheme members receive benefits.
If pensions are pay-as-you-go financed (i.e., out of current contributions) then
the second point at which taxation may occur is lost.
Given three points at which it is possible to levy tax, there are eight basic
tax combinations. There are examples of many of these in practice, but some are
more common and characterise theoretical ideals for the tax system.
Table 1 illustrates four hypothetical régimes.2 The Table shows the net
pension resulting from a contribution of 100 made five years before retirement.
2 The table ignores extreme cases where pensions are taxed at all three possible points or atnone of them, and where either investment returns alone are taxed or alone are exempt.
3
A proportional tax of 25 per cent and a rate of return on investment of 10 per
cent per annum are assumed. The effect of inflation is ignored for the moment.
The first régime exempts contributions from tax, does not tax fund
income, but does tax the pension in payment. This can be termed an exempt,
exempt, taxable (EET) system. The second involves saving out of taxed income,
no tax on the fund's investment return and tax-free withdrawal of pension
benefits, i.e., a TEE system. In this simple framework with a flat tax rate, these
two systems are equivalent in effect. They both confer a post-tax rate of return
to saving equal to the pre-tax rate of return. They are neutral between
consumption now and consumption in retirement. Faced with either régime,
an individual earning 100 now can consume now, paying 25 in tax and buying
goods worth 75, or they can save, allowing consumption of 120.79 in five years.
But 120.79 is simply the amount available for consumption now, increased at
a 10 per cent rate of compound interest, i.e. 75x(1.1)5. This also means these
régimes are equitable in their treatment of different individuals: people who
save for future consumption pay the same tax as those who consume now.
Finally, the two systems also deliver the same net present value of revenues to
the government. However, the timing is different: revenues are deferred until
retirement under EET, but received immediately under TEE.
In practice, the EET and TEE systems may not have the same effect
because of the point at which the tax exemption occurs. If an individual pays a
different marginal income tax rate while in work from the tax rate paid in
retirement, then pre- and post-tax rates of return will no longer be equalised.
The individual will benefit more from a régime granting tax relief when his or
her marginal rate is higher.
Table 1. Alternative pensions taxation régimes
These more unusual régimes are discussed below.
4
EET TEE TTE ETTContribution 100 100 100 100Tax - 25 25 -Fund 100 75 75 100Net investment return 61.05 45.79 32.67 43.56Fund at retirement 161.05 120.79 107.67 143.56Tax on pension 40.26 - - 35.89Net pension 120.79 120.79 107.67 107.67
Net present value of tax 25 33.14 25 33.14Note Assumes 10 per cent annual real return, 25 per cent tax rate and five-year investment term
The last two systems involve taxation at two points. Under the third
régime, savings are made out of taxed income, income earned by the fund is
then taxed but benefits received are exempted (TTE). The tax exemption in the
last system occurs at the point of contribution, while fund income and benefits
are taxable (ETT).
The effects of these two systems are the same in this simple model.
However, the post-tax rate of return is now below the pre-tax rate (7.5 per cent
rather than 10 per cent: 107.67 = 75x(1.075)5). These two systems result in a
disincentive to saving, because consumption now is worth more than
consumption in the future.
The EET and TEE régimes are equivalent to the ‘expenditure tax’ of the
public finance literature3, while the ETT and TTE systems correspond to a
‘comprehensive income tax’. The origin of these names is clear. The first two
régimes tax only consumption (or expenditure) and at the same rate whether
consumption is undertaken now or in the future. In contrast, the last two
systems tax all accruals to income, whether from earnings or investments,
irrespective of whether they are saved or consumed.
These two benchmark tax systems are different ways of interpreting 'fiscal
neutrality' with respect to savings. Equalising pre- and post-tax rates of return
is neutral between present and future consumption. A comprehensive income
3 The EET system is the classical example of an expenditure tax. The TEE system is oftencalled the ‘pre-paid expenditure tax’.
5
tax is neutral between consumption and saving, treating savings in exactly the
same way as any other form of consumption. However, savings are not a
commodity like any other good or service. They are a means to future
consumption, and this is particularly obvious where saving for retirement is
concerned. Neutrality between consumption now and consumption in
retirement is the relevant concept for taxing pensions, and that is the form of
neutrality achieved by the expenditure tax.4,5
2. An international comparison of the tax treatment of pensions
Having examined the taxation of pensions in theory, this section
compares pensions taxation in practice in a range of countries.6
Table 2 summarises the tax treatment of pensions in OECD countries at
three stages identified in the previous section: when contributions are made,
investment returns accrue and when the pension is paid out.7
The first column relates to the personal income tax treatment of
contributions made out of earned income. In most countries — exceptions
include Australia, Iceland and Japan — contributions to a pension are made
out of pre-tax income or attract a tax rebate. The extent of this deductibility is
limited in most countries.
4 On these issues, see Kaldor (1955), Carter Commission (1966), Meade Committee (1978), Pechman (1980), United States Treasury (1977, 1984), Andrews (1974) and IFS Capital TaxesGroup (1995).
5 Unfortunately, optimal tax theory gives little guidance on the appropriate tax treatment ofsavings. The theory shows that the cross-elasticity of labour supply with respect to theinterest rate is a central variable in an intertemporal model, but there is no empiricalagreement on the magnitude of this variable. The only firm conclusion is that neither acapital tax rate of zero (the expenditure tax) nor a capital tax rate equal to the tax on labourearnings (the comprehensive income tax) is optimal.
6 See also Dilnot (1992, 1996a), Johnson (1993) and Whitehouse (1996) for internationalcomparisons of pensions tax incentives.
7 The Table refers to individual pension savings accounts. Employer-based plans aresignificant in a number of countries and their tax treatment is usually similar to personalpensions. Exceptions are Australia and Portugal —where employer contributions are fullydeductible, but employee contributions only partially deductible — and Germany and theUnited States — where employer contributions are deductible but employee contributions are
6
The next three columns relate to the treatment of investment returns. In
most countries, income accruing in the pension fund accumulates tax-free,
although Australia and Sweden apply a special tax rate (15 and 10 per cent
respectively) to pension fund investment returns that is lower than marginal
income tax rates. Denmark taxes only real investment returns, in line with the
‘pure’ comprehensive income tax.
The final two columns of Table 2 cover taxation of the pension in
payment. The tax treatment of withdrawals from the fund, either as an
annuity or a lump sum, varies considerably. All countries bar New Zealand
extract some tax at this point, although there are often tax concessions
available. Australia, Ireland, Japan and the United Kingdom, for example,
allow withdrawal of a tax-free lump sum to be from the fund. In most
countries, withdrawals from the fund before retirement age are not permissible,
although in some, such as Austria and the United States, this is possible
subject to a tax penalty.
taxed.
7
Table 2. Tax treatment of personal pension plans
Country Contributions Pension fund Pension payment NotesPIT PIT Other taxes PIT/CGT
Fundincome
FundIncome
Fundvalue
Pensionincome
Originalvalue
Australia T E T E T E 10% rebate on first A$1,000 (US$670) ofcontributions, phased out when incomeexceeds A$27,000; 15% tax on fund income;lump sums taxed at 16.25% over A$77,000;15% rebate on pension income; deductiblecontributions treated as fringe benefits
Austria E E E E T T 50% of contributions deductible to ceiling;25% of annuity from individual’s contributionstaxable; 30% tax penalty on early withdrawal
Belgium E E E T T T Limits on deductibility of contributions; 0.17%tax on assets of mutual providers (ASBL);tax credit on annuity; 10% tax on lump sums
Canada E E E E T T Pension income credit at basic 17% rate onC$1,000 (US$780) of annuity income
Denmark E E T E T T Real interest taxableFinland E E E E T T 60% of contributions deductible up to ceilingFrance T E E E T T —Germany E E E E T T Contributions deductible to ceiling, which
may be exhausted by compulsory socialsecurity contributions
Iceland T E E E T T —Ireland E E E E T T Limits on deductibility of contributionsJapan T E E E T E Annuity income net of contributions taxable
at standard rates; 50% of net lump sum overY500,000 (US$4,000) taxable
Luxembourg E E E E T T Limits on deductibility of contributionsNetherlands E E E E T T Limits on deductibility of contributionsNew Zealand T E T E E E —Norway E E E E T T Limits on deductibility of contributionsPortugal E E E E T T Limits on deductibility of contributions; 20%
tax on lumps sums net of contributionsSpain E E E E T T Limits on deductibility of contributionsSweden E E T E T T Limits on deductibility of contributions; 20%
tax on fund incomeSwitzerland E E E E T T Limits on deductibility of contributionsUnited Kingdom E E E E T T Limits on deductibility of contributionsUnited States E E E E T T Limits on deductibility of contributions; 10%
tax penalty on withdrawals before age 59½
Source Derived from OECD (1994a), Table 4.4. See OECD (1994b) for more detailed descriptions. Note PIT = personal income tax; CGT = capital gains tax; E = exempt from relevant tax; T = subject to tax.Personal pension plans only, not those provided by employers. Data relate to January 1993. Personalpensions available in Italy since April 1993. Greece and Turkey did not have personal pensions in January1993
8
Table 3 shows tax treatment in a range of countries, most of which have
recently moved, or are proposing to move, towards a funded pension system.
In the majority of Latin American countries, the tax treatment is of the
traditional expenditure tax kind (EET). The only exception is Peru, which has a
pre-paid expenditure tax (TEE). Hungary and Poland have both adopted the
expenditure tax for their new mandatory pension funds. Poland operates a
pre-paid expenditure tax régime for voluntary pension contributions. Hungary
gives a much more generous treatment: exempting investment returns and
pensions in payment as well as giving a tax credit on contributions which
exceeds even the highest tax rate (see the box in the next section). The Czech
Republic taxes its voluntary funds in a similar way, matching contributions up
to a limit.
Table 3. Tax treatment of personal pension plans
9
Contributions Returns Benefits NotesLatin AmericaArgentina E E TChile E E TColombia E E TCosta Rica E E ?Mexico E E TPeru T E EUruguay E E T
Eastern EuropeCzech Republic C E EHungary E E T Mandatory, or ‘second-pillar’, contributions.
Voluntary, ‘third-pillar’ contributions have taxcredit to a limit (CEE)
Poland E E T Second-pillar contributions. Third pillar haspre-paid expenditure tax treatment (TEE)
AsiaIndia E E T Employees’ contributions to voluntary
personal pension plans. Lump sums are taxfree. Contributions to employees’ and exemptor approved provident funds attract a 20%credit
Indonesia E T T Funds’ bank deposits and returns on listedlocal securities tax free; returns on open-ended mutual funds, unlisted securities andproperty taxed
Korea E E EPhilippines T T E Employees’ contributions. Employers’ are
ETE to tax qualified occupational pensionplans and TTE to unqualified plans
Note T=taxed, E=exempt, C=tax credit
Tables 2 and 3 show that most countries’ systems for taxing pensions
approximate to the expenditure tax treatment, that is allowing income tax
deduction of contributions, exempting funds' investment returns and with tax
due on pensions in payment. Twenty-three of 35 countries shown broadly
follow this pattern, although most of them have minor deviations from a pure
expenditure tax. It is also worth noting that these apparently generous
schemes have typically been in place for lengthy periods. Countries that have
recently reformed their pensions tax system have tended to make them less
generous. For example, New Zealand has moved from EET to TTE, and
10
Australia now extracts some tax at all three possible points. In New Zealand,
this has led to a dramatic reduction in pension saving.
In all countries, there are enormous differences between pensions
taxation and the taxation of other forms of savings. For example, housing is
often offered a similar (e.g., Canada, United States) or even more generous (e.g.,
Germany, United Kingdom) treatment than pensions. Direct investment in
equities or bank deposits is taxed more heavily than housing or pensions
almost everywhere.8 Individuals choose where to put their savings not on
economic grounds, such as expected return and risk, but on fiscal grounds.
Many countries have moved recently to reduce differences in tax
treatment.9 Denmark, Finland, Norway and Sweden have implemented the
most extensive reforms, moving towards a flat-rate tax on capital income.
Finland, for example, has introduced a separate flat tax of 25 per cent on
capital income and abolished tax-exempt savings deposits. Norway taxes
interest, imputed income from owner-occupation, dividends etc. at a flat 28 per
cent. In Portugal, the tax reform of 1989 introduced reliefs for retirement and
housing savings accounts and stock option plans. Other countries have
introduced special savings-incentive schemes (often with expenditure-tax
treatment). Examples, which exempt the interest on deposits up to a ceiling,
include the plan d’épargne populaire (PEP) and Livret A accounts in France.
Germany, the Netherlands and Spain simply exempt a fixed amount of interest
income from all sources. Schemes offering limited deduction for equity
investments are available in Austria, Belgium, Canada, France, Germany,
Iceland, Ireland, Luxembourg and Norway. In the United Kingdom, special
schemes for tax-free deposits and equity investments have recently been
merged into a new individual savings account (ISA).10
8 See OECD (1994a). 9 See Whitehouse (1997). 10 See Inland Revenue (1997) and Banks, Dilnot and Tanner (1997).
11
3. Empirical analysis of pension saving incentives
The diversity of taxes, allowances and deductions shown in Tables 2
and 3 gives little guidance to the incentive effects of the taxation of pensions.
This section uses a simplified model of the saving decision to summarise the
effect of different taxes. The approach is adapted from the King and Fullerton
(1984) method used to calculate investment incentives in the corporate
sector.11 The model looks at a saver’s incentives at the margin, that is a small
additional investment in an asset already held, which generates returns just
sufficient to make the saving worthwhile. The analysis assumes a fixed pre-tax
real rate of return of 5 per cent. The fund is invested 40 per cent in bonds and
60 per cent in equities, and dividends account for one third of the real return
on equities, with two thirds from capital gains. Two savers are considered: one
paying the marginal tax rate applicable at the earnings level of the average
production worker12 in the country concerned, the second at the highest rate of
all relevant taxes.
Figures 1 and 2 show the marginal effective tax rate on pension saving in
21 OECD countries in January 1993. Figure 1 shows the marginal effective tax
rate at average earnings and Figure 2 at the top rate of income tax applied to
earnings. The marginal effective tax rates under the two benchmark systems
described above — the expenditure tax and the comprehensive income tax —
are shown for comparison. The effective tax rate under an expenditure tax
would be zero, since the pre-tax return equals the post-tax return. Under a
comprehensive income tax, it would be the top income tax rate or the marginal
rate on average earnings respectively. The figures rank countries by the value
of the marginal effective tax rate.
The Figures show the enormous range of tax treatments. The most
generous scheme offers a tax subsidy of 12 per cent at the tax rate levied on
11 See Annex 2 of OECD (1994a) for a detailed description of the methodology as applied here;OECD (1991) and Scott (1987) provide a detailed discussion of the King-Fullerton approach.
12 See OECD (1997) for a description.
12
average earnings, rising to 26 per cent at top tax rates. The least generous has
a marginal effective tax rate of 73 per cent.
The countries can be divided into four main groups according to the
generosity of their tax treatment. First, a group that grants pensions a more
generous treatment than the expenditure-tax benchmark: Australia, Austria,
Ireland, Portugal and the United Kingdom. Secondly, Canada, Germany,
Luxembourg, the Netherlands, Spain and the United States, who apply an
expenditure-tax treatment to pensions. Thirdly, another six countries —
Denmark, France, Finland, Norway, Sweden and Switzerland — where the
system’s generosity lies between the two benchmarks. Fourthly, the system in
Belgium, Iceland, Japan and New Zealand is even less generous than a pure
comprehensive income tax.
The exact value of the marginal effective tax rate is often very sensitive to
the assumptions used. In particular, no account has been taken of the fact
that a pensioner may often pay income tax at a lower rate than when working..
This is due both to the progressivity of the tax system (incomes in retirement
are generally lower) and due to special tax treatment of pensioners.13 Eleven
OECD countries — Australia, Belgium, Canada, Finland, Ireland, Japan,
Norway, Portugal, Sweden, the United Kingdom and the United States — have
such concessions. For example,
• Canada grants an extra age tax credit of C$3,482, withdrawn above a
ceiling;
• single pensioners in Ireland receive an extra age allowance of IR£400, with
IR£800 for couples;
• a range of deductions in Japan mean the vast majority of pensioners pay no
income tax;
• tax allowances in the United Kingdom are worth between 29 and 34 per cent
13 See OECD (1990) and Disney and Whitehouse (1999), section 6 and Kalisch and Aman (1998),
13
more (depending on age) for single pensioners than for people of working
age, and 39-43 per cent more for married couples; the extra allowance is
withdrawn above a ceiling; and
• the United States offers an extra $1,000 deduction for single pensioners,
and an $1,800 for married couples
Taking account of these concessions would be complex. But the effect
would obviously be to reduce the effective tax rate below the levels shown in
Figure 1 and 2.
Table 7.
14
Figure 1. Marginal effective tax rates on pension savingTax rate at average production worker earnings level
Figure 2. Marginal effective tax rates on pension savingat top rate of tax
Note Calculated at OECD average inflation rate of 3.7 per cent in January 1993. Source OECD (1994a), Tables 5.4, 5.5 and A2.2.
15
A second difficulty is the sensitivity of the tax burden to the level of
inflation. A pure comprehensive income tax would only tax real returns, but
countries which tax investment returns tend to tax nominal returns, meaning
that the real tax burden is sensitive to the level of inflation. The marginal-
effective-tax-rate calculations in Figures 1 and 2 assumed inflation at the
OECD average in January 1993 of 3.7 per cent. Figure 3 looks at the
sensitivity of taxes to inflation, by comparing the earlier results with tax
liabilities under zero inflation, keeping the real return fixed at 5 per cent. The
nominal return is 8.9 per cent in the OECD average inflation case, and 5 per
cent in the zero inflation case.
Figure 3. Marginal effective tax rates on pension savingat OECD average and zero inflation
Source OECD (1994a), Tables 5.4 and 5.6
Given the prevalence of expenditure tax or near expenditure tax
treatments, the marginal effective tax rate is insensitive to inflation in 13
16
countries. Sensitivity to inflation in the other eight countries occurs for a
variety of reasons. Australia, New Zealand and Sweden tax nominal returns as
they accrue, so the tax rate rises with inflation. Japan and Portugal effectively
tax the nominal return by taxing withdrawal of pension net of the amount
contributed. In Belgium, the value of the pension fund may be taxed, and in
Belgium, Denmark and Finland inflation-sensitivity arises from the taxation of
the original value of the asset.
Figure 3 shows that even at low levels, inflation can have big effects on
the net returns to pension savings. The move from zero to 3.7 per cent can
increase the marginal effective tax rate by over 20 percentage points. Inflation
can also have significant distortionary effects on the investments pension funds
make, and it is to the tax treatment of pension funds’ assets which we now
turn.
17
Box. Tax treatment of pensions in Hungary, 1996
The table runs through the tax treatment for two categories of taxpayer: one paying thelowest rate of 20 per cent and the other, the highest rate of 48 per cent. The tableassumes an investment of Ft100, earning a return of 10 per cent a year over five years.
The 50 per cent tax credit means that the fund receives more than Ft100, even fora higher-rate taxpayer. With no tax on the fund earnings or withdrawal, the rate of returnon savings exceeds 20 per cent, more than double the pre-tax rate of return. Thegenerosity exceeds that of an EEE treatment. In contrast, EET or TEE would give a post-tax rate of return of 10 per cent, and ETT or TTE would give 5-8 per cent, depending onthe taxpayer (compare the results here with Table 1).
Table 4. Tax treatment of pensions in Hungary
Ft 20% tax 48% taxEarnings 100 100Tax -20 -48Tax credit 50 50Fund 130 102Fund returns 79.37 62.27Withdrawal 209.37 164.27Rate of return (%) 21.2 25.9
The effect is still more pronounced if account is taken of reduced social-securitycontributions. For every Ft100 switched from current earnings to pension, thegovernment loses Ft42.5 in employer contributions, Ft10 in employee contributions, ontop of the Ft50 tax credit. So, the total loss to government is Ft102.5 for every Ft100deferred from current pay to pension.
(Adapted from Dilnot, 1996b)
4. Pension fund taxation and company taxation
Many discussions of pension fund taxation ignore the tax treatment of
the underlying assets in which pension funds invest.14 Table 5 illustrates the
issue with a highly simplified example based on the tax system in the United
Kingdom before the July 1997 budget. A company earns profits of 100 before
tax and debt interest (initially of 20), and pays out half of net profits as
14 De Ryck (1996), for example, describes the United Kingdom as exempting investment returns. But, as shown below, the effective tax rate on pension funds’ investment returns is substantial.
18
dividends. The corporation tax rate is 31 per cent (the current rate in the
United Kingdom) of profits after interest has been deducted. In the first three
columns, this leaves a net profit of 55.2, of which half (27.6) is distributed.
Under the system before 199x, shown in the first column, the tax rate on
dividends was 25 per cent. However, pension funds, exempted from tax, could
obtain a 25 per cent credit against the tax paid at the company level, which
would be 0.25x27.6/0.75, or 9.2. So net tax receipts under this system were
15.6.
Table 5. Tax treatment of pension fund investment in a simple example company
Full imputation(before 199x)
Partial imputation(199x-1997)
Classical system(1997-)
Switch todebt finance
Gross profits before interest 100 100 100 100Debt interest 20 20 20 40Gross profits after interest 80 80 80 60
Tax at 31% 24.8 24.8 24.8 18.6Net profit 55.2 55.2 55.2 41.5
Dividend 27.6 27.6 27.6 13.9Retained profits 27.6 27.6 27.6 27.6
Tax credit 9.2 6.9 0 0
Net tax paid 15.6 17.9 24.8 18.6
The 199x budget cut the basic rate of tax on dividends to 20 per cent.
But at the same time, the tax credit was cut to 20 per cent. Despite the
apparent cut in tax, the effect was to raise tax on pension funds’ investments
as the tax credit falls to 0.2x27.6/0.8 or 6.9. Net tax receipts increase from
15.6 to 17.9, or 14 per cent.
Assuming 50 per cent of profits were paid as dividends, the effective tax
rate on domestic equity investment was 0.5x0.31 + 0.5x(0.31-0.2), or 21 per
cent. Domestic equities comprise 52 per cent of pension funds’ portfolios, with
overseas equities making up a further 23 per cent. Assuming that other
countries’ corporate income tax rate is also 31 per cent, then the effective tax
rate on pension funds under this system would be 0.52x0.21 + 0.23x0.31, or
18.1 per cent.
19
The tax credit was abolished altogether in the 1997 budget by the
incoming New Labour government. So although pensions funds remain exempt
from tax on their dividends, there is no longer any allowance made for taxes
paid at the company level. The net tax revenues in this simple model are now
24.8 (31% of 80). This increases the effective tax rate on domestic equities
from 21 to 31 per cent. The overall effective tax rate on pension funds, with a
total of 76 per cent invested in equities, is therefore 0.76x0.31, or 23.6 per
cent. As this is a little higher than the standard rate of income tax (23 per
cent), the true tax régime for standard-rate taxpayers is ETT rather than EET.
One likely impact of this reform is to encourage companies to switch
from equity to debt finance, either from loans or bond issues. Debt interest
increases from 20 to 40 in the final column of Table 5. Retained profits remain
at 27.6, leaving 13.9 for the dividend. However, net tax receipts fall to 18.6,
and so the net return to pension fund investors (as bond and shareholders)
increases. There is already evidence of companies organising their finances to
avoid tax in this way.
5. Distributional issues and restrictions on pension contributions
Table 2 shows that most countries restrict the extent to which pension
contributions can be deducted from the personal income tax. This is normally
to circumscribe tax avoidance or because of distributional concerns. Higher-
income individuals are better able to make pension contributions, and receive a
larger tax advantage because of the deductibility of contributions against
higher rates of income tax.
Limits on deductibility can take a number of forms:
• absolute limits on the amount of contributions (e.g. Australia, Germany)
• limits on the proportion of contributions that can be deducted (e.g. Austria,
Finland)
• limits on the proportion of income on which contributions can be made (e.g.
20
United Kingdom)
• limits on the deductibility of contributions at higher rates of income tax
Table 6 investigates the last of these further using the simple framework of
Table 1. The first four columns look at an individual who pays a higher tax
rate, assumed to be 40 per cent, during both their working life and retirement.
The first column shows the standard expenditure-tax treatment. Since
contributions are deductible at the higher rate, the result up to retirement is
the same as for the standard rate taxpayer in Table 1. After retirement,
however, 40 per cent tax is payable, so the net pension is just 96.63. Again,
the tax is neutral over the timing of consumption: the individual can consume
60 now or 96.63 = 60x(1.1)5. Again, the classical expenditure tax has the same
effect as the pre-paid expenditure tax, shown in the second column.
The deductibility of pension contributions is restricted to the standard
rate of tax — assumed to be 25 per cent — in the third column. Partial
deductibility means the gross contribution of 100 is reduced by 15 (the
difference between the higher and standard rates). The result is a lower
pension — 82.14 or 15 per cent lower — than the unrestricted expenditure tax.
However, although the pension is 14 lower, the net present value of tax
receipts is only nine higher. The partial taxation of contributions means there
is less to tax when the pension is paid.
The fourth column shows a comprehensive income tax at a 40 per cent
rate. This shows that restricting the deductibility of contributions is close to
introducing a comprehensive income tax. Moreover, the arguments for and
against this treatment can also be applied to the argument that contributions
should not be deductible at higher rates of income tax.
21
Table 6. Alternative tax treatments for higher-rate taxpayers
Higher rate in work and retirement Higher rate in work, basic rate in retirementEET TEE with limit ETT EET TEE with limit ETT
Contribution 100 100 100 100 100 100 100 100Tax 0 40 15 0 0 40 15 0Fund 100 60 85 100 100 60 85 100Net investment return 61.05 36.63 51.89 43.56 61.05 36.63 51.89 43.56Fund at retirement 161.05 96.63 136.89 133.82 161.05 96.63 136.89 133.82Tax on pension 64.42 0 54.76 53.53 40.26 0 34.22 33.46Net pension 96.63 96.63 82.14 80.29 120.79 96.63 102.67 100.37
Net present value of tax 40 40 49 50.14 25 40 36.25 37.68
The final four columns show a similar analysis for a person who pays the
higher rate of tax when contributions are paid and investment returns accrue,
but pays the standard rate of tax during retirement. Column five shows that
the classical expenditure-tax treatment delivers the same pension and tax
receipts as for people who pay the standard rate of tax during their working life
(compare Table 1). But the pre-paid expenditure tax raises more revenue than
the classical tax from people who are higher-rate taxpayers when working and
standard-rate taxpayers when they draw their pension.
Again, restricting the deductibility of contributions to the basic rate
(column seven) reduces the pension compared with unrestricted deductibility.
It also raises the tax take, but the initial gain from restricted deductibility is
offset by the loss from the lower revenues on the lower pension. The net effect
is again close to the comprehensive income tax (column eight).
6. An international comparison of pension funds
Table 7 gives an indication of the scale of pension funds in a selection of
OECD countries. In eight of them — Canada, Finland, Ireland, Japan, the
Netherlands, Switzerland, the United Kingdom and the United States —
pension funds’ assets exceeded 40 per cent of GDP in 1996. In seven others —
Austria, Belgium, the Czech Republic, Hungary, Italy, Korea and Spain —
pension fund assets are much smaller, less than 5 per cent of GDP. These
differences reflect varied levels of private pension provision and differences in
22
pension financing. In the countries with the largest pension fund sectors,
coverage of employees in employer-provided pension plans varies between 50
per cent in the United Kingdom and 90 per cent in Switzerland.15 In Belgium,
for example, coverage is less than 5 per cent, whereas in France, although
coverage is broad, most schemes are pay-as-you-go.
Table 7. Pension-fund assets as a percentage of GDP, 1987-96
Country 1987 1990 1993 1996Switzerland 75 73 82 117
Netherlands 46 78 84 87
United Kingdom 62 60 72 75
United States 36 38 53 58Ireland — 32 40 45Canada 26 30 36 43Japan 38 37 41 42Finland 20 25 38 41
Sweden 33 31 27 33Australia — 18 30 31Denmark 11 12 19 24Luxembourg 20 20 18 20
Greece — 7 8 13Portugal — 2 6 10Norway 4 5 6 7Germany 3 3 6 6France — 3 3 6Belgium 2 3 3 4Spain — 2 2 4Korea 3 3 3 3Italy — — 2 3Austria — — 1 1Czech Republic — — — 1Hungary — — — 0
Source OECD (1998a), Table V.1Note Figures for Denmark include company pension funds only in 1996 and for Germany for 1993 and
1996 only. Figures for Finland cover financial assets only. First pillar assets are included in Swedenfor 1987 and 1990.
In the eight countries with the largest pension funds, there has been
15 OECD (1992).
23
rapid growth in their assets: by an average of 56 per cent over the nine-year
period. This growth reflects the maturing of private pension schemes in many
countries. In the United Kingdom, for example, private sector pension funds
had five contributors for every pensioner in 1970, falling to fewer than two in
1991.16 Pension funds also grew because of high real rates of return. In
Ireland, these were 11 per cent a year between 1984 and 1996, 8 per cent in
the Netherlands, 4 per cent in Switzerland, 10 per cent in the United Kingdom
and 9 per cent in the United States.17
In many of these countries, pension funds are an important source of
capital. They own a third of equities in the United Kingdom and United
States.18 In the Netherlands and the United States, pension funds own around
40 per cent of corporate bonds. Ownership of financial assets is also
concentrated in some countries which have introduced funded pension
systems more recently. For example, Chilean funds account for 43 per cent of
stock-market capitalisation, and Argentine funds for 15 per cent.
Table 8 shows pension fund assets in a range of Latin American
countries that have recently introduced funded defined-contribution pension
systems. Chile, which reformed its system in 1981, now has $33bn in its
pension funds, or 44 per cent of GDP. Of the others, Argentina, which
reformed its system in 1994, has the largest funds at $9bn, almost 3 per cent
of GDP. However, growth in Argentina has been slower than in Chile, where
funds exceeded 8 per cent of GDP three years after reform.
Table 8. Pension fund assets as a percentage of GDP,December 1997
16 Appendix 5.1 of Dilnot et al. (1994). 17 OECD (1998a), Table V.3. 18 OECD (1998a) and Davis (1995). See also Brancato (1994) on the United States and Hoffmanand Lambert (1993) on the United Kingdom.
24
Country Assets, % of GDPChile 44.1Argentina 2.8Peru 2.1Colombia 1.3Uruguay 1.0Mexico 0.2
Source Queisser (1998) based on Uruguay, Central Bank (1997), Comision Nacional del Sistema de Ahorropara el Retiro (1997), Primamerica (1997) and Superintendencia de Administrado de Fondos deJublicaciones y Pensiones (1997)
There is some correlation between tax treatment and the size of pension
funds, but a number of exceptions. Austria and Portugal give among the most
generous tax privileges to pensions, but have relatively small funds. In
Austria’s case, this probably reflects the size of the public pension system
(Table 9). This is also likely to apply to Germany and Spain, where pension
funds are relatively small despite the expenditure tax treatment.19 At the other
end of the spectrum, Finland and Japan have large pension funds but tax
private pensions closer to the comprehensive income tax than the expenditure
tax. A generous tax treatment seems neither a necessary nor a sufficient
condition for large private pension funds. The regulatory and industrial
relations régimes, historical factors as well as the public pension system will
also affect the size of private funds.
19 The book reserve financing system in Germany also complicates the analysis.
25
Table 9. Public pensions in OECD member countries
Percentage of GDP 1980 1985 1990 1995Italy 9.1 11.3 12.0 13.6Austria 11.7 12.6 12.5 13.4France 9.8 10.9 11.1 12.2
Greece 6.1 9.8 10.5 —Germany 10.8 10.8 10.1 10.9Luxembourg 10.8 10.1 9.7 10.4Belgium 9.4 10.0 9.4 10.3
Spain 6.5 7.9 8.1 9.2Finland 5.7 7.6 7.5 9.1Sweden 6.8 7.4 7.5 8.2
Denmark 6.1 6.0 6.6 7.8Netherlands 8.0 7.9 8.8 7.8Portugal 4.2 4.6 5.4 7.7OECD mean 6.6 7.0 6.9 7.5United Kingdom 6.8 7.1 7.1 7.3Switzerland 6.1 6.3 6.0 7.1Czech Republic — — 6.1 6.4Japan 4.0 4.8 5.0 6.3United States 6.1 6.2 6.0 6.3Norway 5.1 5.2 6.3 6.2
New Zealand 6.9 7.5 7.6 5.8Canada 3.0 3.8 4.3 4.8Iceland — — — 4.2
Turkey 1.7 1.8 3.2 3.7Ireland 4.3 4.5 4.0 3.5Australia 3.9 3.7 3.4 3.4
Korea — — 0.8 1.4Mexico — 0.3 0.3 0.4
Source Preliminary data from OECD (1998b)Note OECD mean calculated using only countries for which all for years of data are available
There is a reasonable negative correlation between the size of public and
private pension systems. Italy and Austria, for example, with the largest public
pension expenditures, have among the smallest private pension funds. But
countries with the smallest public pension systems, with the exceptions of
Australia and Ireland, also tend to have small private pension funds. This is
probably because the five lowest-spending countries — Australia, Ireland,
Korea, Mexico, Turkey — also have the lowest aged dependency ratio of the
OECD countries.
26
Table 10. Public pensions as a percentage oftotal pensioner income
Country Per centGermany 78Australia 77Sweden 75France 68Netherlands 66United Kingdom 62Italy 61Japan 52United States 46
Source Börsch-Supan (1998).
Private pensions perform an important and growing role in providing
incomes in old age as well as a sizeable asset base in many of these countries.
Table 10 shows the proportion of pensioners’ incomes derived from public
pensions in a selection of OECD countries. Private income sources range from
over half in the United States to a little over a fifth in Germany. In many
countries, the importance of private sources has been growing. In the United
Kingdom, for example, private income sources were under 40 per cent of total
incomes in 1979, rising recently to more than half. This trend is likely to
continue: among recently retired pensioners (in the first five years over state
pension age), private income sources are 60 per cent of the total.20
7. Measuring the revenue cost of pensions taxation incentives
The concept of a ‘tax expenditure’ was developed in recognition of the fact
the tax system can be used to achieve similar goals to public spending
programmes, but accounting for the costs and benefits of tax measures is often
less rigorous and regular than for direct expenditure. A tax expenditure is said
to exist when the tax system deviates from some benchmark tax system. In
general, this norm includes the tax rate structure, accounting conventions,
20 Department of Social Security (1994, 1997). See Whitehouse (1998) for a discussion.
27
administrative provisions and provisions relating to international fiscal
obligations. Defining a tax expenditure in practice can be difficult: some tax
measures may not be readily classified as part of the benchmark or an
exception to it.21 Tax expenditures are usually calculated using the so-called
‘revenue forgone’ method, which computes the tax that would have been
payable ceteris paribus if the tax concession were removed, and economic
behaviour remained unchanged. Fourteen OECD countries now produce tax-
expenditure reports.
With three occasions at which they might be taxed, pensions offer a
broad range of possible benchmarks, a subset of which were presented in Table
1. Countries' methods of calculating tax expenditures for pensions differ, and
a number of countries (including Belgium, Canada and the United Kingdom)
have recently changed their methods of reporting tax expenditures for
pensions. In Australia, Canada, Spain and the United States, the
comprehensive income tax — with pension benefits tax-free and contributions
and investment returns taxed — is used as the benchmark. Usually, however,
there is no inflation adjustment, so nominal rather than real returns are taxed.
In the United Kingdom, the actual tax treatment is compared with a so-called
‘unapproved’ scheme, where contributions and investment returns are taxed
but the withdrawal of the pension as a lump sum is tax-free. This is equivalent
to the comprehensive income tax treatment (i.e., TTE). Other countries (such
as the Netherlands) do not report tax expenditures for pensions at all, or (for
example, Germany) choose a benchmark very much closer to the actual
system.
The results are highly sensitive to the choice of benchmark. The
difference in the results between measuring the cost against the comprehensive
income tax and the expenditure tax can be seen from the relative positions of
the two lines in Figures 1 and 2. The baseline against which the actual
21 See OECD (1984, 1995) and Surrey (1975) for a detailed discussion.
28
treatment is compared is between 25 and 50 per cent higher (depending on the
country’s tax system) in the comprehensive income tax case. Dilnot and
Johnson (1993a,b) argue that, since an expenditure tax is the most appropriate
tax treatment for pensions, tax expenditures should be calculated against this
norm. A second argument for using an expenditure tax as benchmark is that
in response to the abolition of pension tax incentives, savings would flow to
similarly fiscally privileged assets. Taking account of behavioural responses,
the extra revenue raised from abolishing pensions tax incentives would be
small. Dilnot and Johnson found that the United Kingdom tax expenditure on
pensions was just £1bn when measured in this way, compared with around
£7bn reported in official figures at the time of their study.
Table 11 shows tax expenditures relating to pensions reported by OECD
governments in national currencies and as a percentage of total tax receipts.
Compared with a comprehensive income tax base, over 3 per cent of income tax
revenues are forgone in Australia, Canada, the United Kingdom and the United
States. In Canada and the United Kingdom, pensions are the largest item in
tax expenditure accounts; in the United States, they are the second largest,
after health insurance. These tax expenditures are also large when compared
with direct public spending. In the United Kingdom, for example, the total
reported in the tax expenditure accounts for 1996-97 was over £10bn
compared with £30bn spent on state pensions.
However, because of the use of different benchmarks in computing
revenues forgone, many of these figures are not strictly comparable between
countries. Nor, because of behavioural responses, are they an accurate
indication of the revenues that the removal of tax reliefs for pensions would
raise.
29
Table 11. Revenue cost of pensions tax incentives
Country Tax expenditure Year Amount % of totaltax revenue
Australia Concessional treatment of superannuation contributions,fund income and benefits paid
1992-93 A$5.3bn 4.6
Belgium Private pension savings 1989 BF 8.9bn 0.3Employer pension schemes (‘Assurance-Groupes’) 1988 BF 3.7bn 0.1
Canada Registered retirement saving plans 1989 C$3.23bn 2.5Registered pension plans 1989 C$7.7bn 5.9
Finland Tax exemption of national pension supplements, etc. 1991 FMk 0.7bn 0.3Pension income deduction in municipal taxation 1991 FMk 3.1bn 1.5
Germany Flat rate tax of 15% on taxable employer contributions tocompany pension schemes
1991 DM 1.7bn 0.2
Ireland Employees’ contributions to approved superannuationschemes
1990 IR£53m 0.5
Exemption of the income of approved superannuationfunds
1990 IR£200m 2.0
Retirement annuity premiums of theself-employed
1990-91 IR£23m 0.2
Portugal Retirement savings schemes 1992 Esc 2.8bn 0.1Spain Tax incentives for pension funds 1993 Ptas 16bn 0.1Sweden Pension funds 1992 SKr 9.7bn 1.3United Kingdom Occupational pensions - income tax relief 1996-97 £8.0bn 3.0
Contributions to personal pensions – income tax relief(including retirement annuity premiums and 'free-standingadditional voluntary contributions')
1996-97 £2.2bn 0.8
United States Employer plans 1991 $48bn 3.0IRAs 1991 $6.9bn 0.4Keogh plans 1991 $1.6bn 0.1
Note Figures are not comparable between countriesSource OECD (1994a, 1995), Australia, Department of the Treasury (1994), Belgium, Chambre des
Représentants (1992), Canada, Department of Finance (1993), United Kingdom, HM Treasury(1997), United States, Joint Committee on Taxation (1993) and Treasury (1994)
8. Objectives for the tax system
The first section of the paper argued that the expenditure tax was the
most appropriate treatment for pension savings because it is neutral in the
allocation of consumption between the working life and retirement. There are
further reasons, including ones of equity and simplicity, for thinking that an
expenditure tax might offer the best way of taxing pensions.
First, identifying investment returns, especially those in the form of
unrealised capital gains, can be difficult. Taxing gains on realisation rather
30
than as they are accrued causes different problems.22
Secondly, as the marginal effective tax rates in Figure 3 showed, the
comprehensive income tax has difficulty dealing with inflation. Taxing
investment returns often means that nominal returns are taxed, meaning the
post-tax real return falls still further below the pre-tax real return. If, for
example, the real interest rate were 2.5 per cent, and inflation 7.5 per cent,
then the TTE and ETT systems without inflation adjustment would result in the
net pension showing no real return. The 7.5 per cent post-tax nominal return
is only just enough to compensate for inflation. A higher level of inflation
would deliver negative real returns. Many OECD countries do tax certain
assets this way, such as ordinary interest-bearing deposits.23 By contrast, the
expenditure tax, by avoiding taxing investment returns, maintains equal pre-
and post-tax real returns whatever the mix of inflation and real returns in the
nominal interest rate.
However, a comprehensive income tax raises more revenue at a given tax
rate: the discounted total tax take is 25 under the expenditure tax and 33
under the comprehensive income tax in the example given in Table 1. The
broader tax base of comprehensive income allows a lower tax rate to collect the
same revenues. A 20.5 per cent rate in the simple model would raise the same
revenues as an expenditure tax with a 25 per cent rate. This could have
important economic effects through labour-supply incentives and the incentive
to work in the ‘black’ or ‘shadow’ economy.24 But it still means savings choices
22 Defined-benefit plans (where the value of the pension benefit is related to some measure ofearnings and years of scheme membership) raise further administrative difficulties. At anypoint during scheme membership, the value of the pension depends on two future, uncertainvariables — the total duration of membership and future earnings — and so the value of fundand investment returns cannot be allocated to individuals. When marginal income tax ratesvary (as in any progressive tax system), it is not possible to find the appropriate tax rate toapply to the pension fund, unless some arbitrary rate is used. This also applies tocontributions to the fund: in a defined benefit plan, these bear no relation to the pensionbenefit being accrued, and employer contributions are typically made as some percentage ofthe aggregate payroll (Disney and Whitehouse, 1994, 1996).
23 See OECD (1994), Table 4.1. 24 However, dynamic models of the economy suggest that wage earners benefit from the lower
31
are distorted. An individual could choose to consume 79.5 now or save for
retirement and consume 116.5 then. But that is equivalent to just 72.3 at
working age (or, equivalently, the neutral consumption in retirement would be
128).
An expenditure tax may also affect portfolio choice. Since pensions are
taxed on withdrawal under the classical expenditure tax (EET), the government
becomes a co-investor, sharing in any rents, but also participating in any
losses. This may encourage a riskier choice of portfolio.25
A second concept of fiscal neutrality with respect to savings decisions is
neutrality between different types of savings instruments.26 If one savings
medium is taxed more lightly than others are, then it will tend to attract funds
at their expense. Economic inefficiency results as decisions are distorted
compared with those that would be made in a tax-free environment. In many
countries, saving for retirement is treated favourably compared with other
savings media. A number of arguments have been proposed to support this
relatively generous treatment:
• the state should ensure that people maintain a standard of living in
retirement approaching the level when they were of working age;
• by encouraging individual provision for retirement, the cost of social
security benefits may be reduced, particularly when means-tested benefits
are an important source of retirement income; and
• the state should increase long-term savings to add to the level and/or
stability of capital available for investment.
taxation of capital under an expenditure tax. The economy’s capital stock is higher,increasing productivity and wages.
25 Of course, this may be corrective if investors suffer from myopic risk or loss aversion. 26 Hamilton and Whalley (1985) find that this type of neutrality is extremely important. They
find that both a comprehensive income tax and expenditure tax which treat all savingsequally dominate a hybrid system with an expenditure tax treatment for housing and acomprehensive income tax treatment for everything else. The reduced price distortionbetween assets dominates the effect of reduced distortion of intertemporal choice. See alsoHamilton (1987).
32
The first argument is a paternalist one; the state gives incentives to save
for retirement (relative both to current and to future, pre-retirement
consumption) because in the absence of incentives, individuals will fail to make
‘sufficient' provision.27 There are a number of reasons why, first this rationale
may not be valid and, secondly, why the tax system is not a good way of
achieving it. It is hard to define ‘sufficiency’ of retirement income beyond an
adequate minimum. Offering tax incentives for retirement saving may not
ensure that everyone achieves a minimum standard; some will still fail to
provide whereas others may even over-provide.28 Other means of ensuring that
retirement living standards approach the level during working life may be more
effective and, perhaps, less distortionary: for example, the state can adjust the
level of compulsory private pension contributions (the ‘second pillar’).
The second argument is one of ‘moral hazard’ — individuals will not
provide for themselves if they know the state will give them an adequate income
anyway. Pensions are partly — e.g. in the United Kingdom — or wholly — e.g.
in Australia — means-tested in a number of countries. This means-testing
produces a substantial disincentive to save for retirement, especially for people
with low incomes. Again, however, it does not follow that attaching fiscal
privileges to pensions is an effective way of minimising the cost to the state,
compared, for example, with mandating a certain level of contributions. The
reduction in current revenues that results from the tax incentive adds to this
argument.
Tax incentives for pensions appear to increase pension savings.
Examples include the ‘success’ of registered retirement savings plans, RRSPs,
in Canada, personal pensions in the United Kingdom, and individual
27 Diamond (1977) and Samuelson (1987).28 Other individuals may be ‘over-annuitised’, i.e. hold more of their wealth in the form of
annuities (which cannot be bequeathed) than they would wish in the absence of taxprivileges.
33
retirement accounts, IRAs, in the United States.29 Whether this results,
however, from a substitution of pensions for other savings media or from an
increase in overall savings is difficult to ascertain. If people have a fixed target
for retirement savings, a new tax incentive for pensions could induce them to
reduce current savings, since their level of retirement income would remain the
same. Tax incentives cost the government by reducing revenues, cutting public
sector saving. Even if household savings increase, the overall effect on national
saving is uncertain.
The empirical evidence on the effect of tax incentives on savings is
inconclusive. Alan Blinder commented,
‘...there is zero evidence that tax incentives that enhance the rate of
return on saving actually boost the national saving rate. None. No
evidence. Economists now accept that as a consensus view’.30
Many empirical studies of household saving, particularly of IRAs in the United
States, have found a positive effect31, although others are sceptical.32 The
OECD (1994a) study of taxation and savings concludes its survey of evidence
in a number of countries,
‘There is no clear evidence that the level of taxation, along with other
factors affecting the rate of return, does generally affect the level of
saving’.33
Given the inconclusive nature of this literature, it does not seem wise to
suggest that a desire to increase economy-wide saving either is or should be a
major objective for the taxation of pensions. Changing the composition of
saving towards long-term retirement savings might at times, however, be a
29 See Carroll and Summers (1987) on RRSPs, Disney and Whitehouse (1992a,b) on personalpensions, and Venti and Wise (1986, 1987) and Gravelle (1989, 1991) on IRAs.
30 Interview in Challenge, September-October 1992 quoted by Gylfason (1993).31 See, for example, Hubbard (1984), Venti and Wise (1987), Feenberg and Skinner (1989) and
Poterba, Venti and Wise (1996). 32 For example, Gravelle (1989, 1991), Munnell (1986) and Engen, Gale and Scholz (1994). 33 OECD (1994a), p. 189. See also Robson (1995) and Boadway and Wilasdin (1994) for a
discussion.
34
useful policy tool.
Having established the desirability of expenditure tax treatment for
pensions and of a ‘level playing field’ for different types of saving, the final
policy choice is between the classical expenditure tax (EET) and the pre-paid
expenditure tax (TEE).
The pre-paid expenditure tax has much to recommend it. First, by
bringing the revenues from pension taxation forward compared with the
deferred taxation in the classical expenditure tax, it alleviates the transitional
pension deficit when moving from a pay-as-you-go to a funded system. The
outgoing Conservative government in the United Kingdom proposed such a
scheme in 1997.34 Croatia has also adopted the pre-paid expenditure tax.
Secondly, it limits tax avoidance and evasion by ensuring the government
collects the money up-front. It also ensures revenues can be collected from
foreign workers or people who intend to emigrate on retirement. Thirdly, it will
raise more revenues from people who are higher-rate taxpayers during their
working life but pay tax at the standard rate during retirement.35
However, the pre-paid expenditure tax has two major drawbacks. First,
although the tax incentive may be equivalent to a classical expenditure tax,
psychology suggests that the up-front tax relief is perceived as more valuable.
Financial-services companies also find up-front reliefs a better selling point.36
Secondly, the pre-paid expenditure tax subjects funded pensions to ‘policy
risk’. A future government may not feel bound by commitments of previous
governments not to tax pensions in payment or investment returns, and may
view pension funds as an easy revenue target. This is likely to undermine the
attractiveness of funded pensions to potential investors.
34 This is the so-called ‘basic-pension-plus’ scheme. See Whitehouse (1998), section VI,Department of Social Security (1997) and Whitehouse and Wolf (1997).
35 The effect can be seen by comparing the first and fourth columns in Table 6. The TEEtreatment would still produce a net pension of 96.63 if the taxpayer were a higher-ratetaxpayer while in work and standard-rate taxpayer in retirement.
36 See Thaler (1994).
35
9. Conclusions
36
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